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Chapter 7: Problem 8

Decision Trees B\&B has a new baby powder ready to market. If the firm goes directly to the market with the product, there is only a 55 percent chance of success. However, the firm can conduct customer segment research, which will take a year and cost \(\$ 1.8\) million. By going through research, B\&B will be able to better target potential customers and will increase the probability of success to 70 percent. If successful, the baby powder will bring a present value profit (at time of initial selling) of \(\$ 28\) million. If unsuccessful, the present value payoff is only \(\$ 4\) million. Should the firm conduct customer segment research or go directly to market? The appropriate discount rate is 15 percent.

Short Answer

Expert verified
The expected present value of conducting customer segment research (\$16.525 million) is greater than the expected present value of going directly to market (\$15.4 million). Therefore, B&B should conduct customer segment research before marketing their new baby powder.

Step by step solution

01

Calculating Expected Present Value - Going Directly to Market

First, let's calculate the expected present value (PV) for going directly to market without any customer segment research. The probability of success is 55%, which means there is a 45% probability of failure. We can find the expected PV using these probabilities and the given payoffs: Expected PV = (probability of success 脳 PV if successful) + (probability of failure 脳 PV if unsuccessful) Expected PV = (0.55 脳 \$28 million) + (0.45 脳 \$4 million) = \(\$15.4 million)
02

Calculating Expected Present Value - Conducting Customer Segment Research

Next, we're going to calculate the expected present value if the company conducts customer segment research. After the research, the probability of success increases to 70%, so the probability of failure is 30%. However, we have to take into account the \$1.8 million cost for conducting the research and the fact that it takes one year to complete. First, let's calculate the present value of the cost spent on research, discounted by the discount rate of 15%: PV_cost = \$1.8 million / (1 + 0.15) = \(\$1.565 million) Now, let's find the expected PV for this scenario: Expected PV = (probability of success 脳 PV if successful) + (probability of failure 脳 PV if unsuccessful) Expected PV = (0.7 脳 \$28 million) + (0.3 脳 \$4 million) = \(\$20.8 million) However, since the research takes one year, we need to discount the expected PV using the discount rate to find its present value: PV_research = \$20.8 million / (1 + 0.15) = \(\$18.09 million) Finally, we have to subtract the present value of the research cost: PV_research - PV_cost = \$18.09 million - \$1.565 million = \(\$16.525 million)
03

Comparing Expected Present Values

Now, we can compare the expected present values of the two strategies: 1. Going directly to market: \$15.4 million 2. Conducting customer segment research: \$16.525 million Since the expected present value of conducting customer segment research (\$16.525 million) is greater than the expected present value of going directly to market (\$15.4 million), B&B should conduct customer segment research before marketing their new baby powder.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Expected Present Value
The Expected Present Value (EPV) is a crucial financial metric that helps businesses decide on the best course of action by analyzing potential outcomes. It combines the possible financial returns from an investment with the likelihood of achieving those returns. EPV can be thought of as a weighted average of all potential outcomes, using probabilities as weights. The formula for calculating the EPV for a decision is:
  • EPV = (Probability of Success 脳 PV if Successful) + (Probability of Failure 脳 PV if Unsuccessful)
So, in the context of B&B's decision about their baby powder, this metric is used to determine whether to proceed directly to the market or to first conduct customer segment research. If going directly to market, the EPV is calculated using a 55% probability of success, resulting in an EPV of $15.4 million. For the scenario where customer research is conducted, the probability of success increases to 70%, and after accounting for research costs, the EPV becomes $16.525 million, suggesting this option is more financially attractive.
Probability of Success
Probability of success is a key factor in decision-making, representing the likelihood that a particular investment or project will yield positive results. This probability can significantly change the expected value of an investment. In B&B's case, initially, there is a 55% probability of successfully launching the baby powder if they opt to directly go to market. This reflects the chance of achieving the projected returns without additional insights from market research. However, by investing in customer segment research, B&B can enhance their strategic insights, thereby increasing the probability of success to 70%. This increase demonstrates the value of thorough research, as it aligns product offerings with customer needs, improving the chances of success and ultimately leading to a greater expected present value. Thus, understanding and accurately estimating this probability is crucial for evaluating different strategic options.
Customer Segment Research
Customer segment research involves gathering detailed insights about different groups of potential customers. It helps a company tailor its products or marketing strategies to better meet the needs of specific segments. This research can significantly impact the probability of success for a product by aligning it more closely with consumer preferences. For B&B's baby powder, conducting this research comes with a cost of $1.8 million and requires a year to complete. The benefit, however, is clear: it raises the probability of success from 55% to 70%. This increase justifies the expenditure and time by potentially enhancing product-market fit. Engaging in comprehensive customer segment research helps in creating a more effective and potentially lucrative marketing strategy, as shown in B&B's consideration of expected values.
Discount Rate
In financial analysis, the discount rate is used to determine the present value of future cash flows. It accounts for the time value of money, recognizing that funds available today are more valuable than the same amount in the future due to their potential earning capacity. For B&B's decision-making process, a 15% discount rate is applied to project future cash flows back to their present value. This rate helps calculate how much future revenues and costs are worth in today's terms. Applying this discount rate, B&B finds the present value of the research costs to be $1.565 million. Similarly, the expected present value of future profits, after research, gets discounted to $18.09 million before considering research costs. Understanding how to apply the discount rate is essential for evaluating long-term projects, as it aids in comparing the viability of different investment options by providing a clearer financial picture.

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Most popular questions from this chapter

Option to Wait Your company is deciding whether to invest in a new machine. The new machine will increase cash flow by \(\$ 340,000\) per year. You believe the technology used in the machine has a 10 -year life; in other words, no matter when you purchase the machine, it will be obsolete 10 years from today. The machine is currently priced at \(\$ 1,800,000\). The cost of the machine will decline by \(\$ 130,000\) per year until it reaches \(\$ 1,150,000\), where it will remain. If your required return is 12 percent, should you purchase the machine? If so, when should you purchase it?

Abandonment Value We are examining a new project. We expect to sell 9,000 units per year at \(\$ 50\) net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be \(\$ 50 \times 9,000=\$ 450,000\). The relevant discount rate is 16 percent, and the initial investment required is \(\$ 1,900,000\). 1\. What is the base-case NPV? 2\. After the first year, the project can be dismantled and sold for \(\$ \mathbf{1 , 3 0 0 , 0 0 0}\). If expected sales are revised based on the first year's performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project? 3\. Explain how the \(\$ 1,300,000\) abandonment value can be viewed as the opportunity cost of keeping the project in one year.

Sensitivity Analysis Consider a four-year project with the following information: Initial fixed asset investment \(=\mathbf{\$ 3 8 0 , 0 0 0}\); straight-line depreciation to zero over the four-year life; zero salvage value; price \(=\$ 54\); variable costs \(=\$ 42 ;\) fixed costs \(=\$ 185,000\); quantity sold \(=90,000\) units; tax rate \(=34\) percent. How sensitive is OCF to changes in quantity sold?

Financial Break-Even Analysis You are considering investing in a company that cultivates abalone for sale to local restaurants. Use the following information: The discount rate for the company is 15 percent, the initial investment in equipment is \(\$ 360,000\), and the project's economic life is seven years. Assume the equipment is depreciated on a straight-line basis over the project's life. 1\. What is the accounting break-even level for the project? 2\. What is the financial break-even level for the project?

Scenario Analysis Consider a project to supply Detroit with 55,000 tons of machine screws annually for automobile production. You will need an initial \(\$ 1,700,000\) investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be \(\$ 520,000\) and that variable costs should be \(\$ 220\) per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of \(\$ 300,000\) after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of \(\$ \mathbf{2 4 5}\) per ton. The engineering department estimates you will need an initial net working capital investment of \(\$ 600,000\). You require a 13 percent return and face a marginal tax rate of 38 percent on this project. 1\. What is the estimated OCF for this project? The NPV? Should you pursue this project? 2\. Suppose you believe that the accounting department's initial cost and salvage value projections are accurate only to within \pm 15 percent; the marketing department's price estimate is accurate only to within \pm 10 percent; and the engineering department's net working capital estimate is accurate only to within \pm 5 percent. What is your worst-case scenario for this project? Your best-case scenario? Do you still want to pursue the project?
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